Study of the Week: Is Low Volume Predicting a Market Crash?

Low volume isn't bearish no matter how you slice it.

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With the SPX (INDEXSP:.INX) back up near new highs, we are beginning to hear a common concern: Volume is low and this is bearish. The theory is that you need high volume to confirm any bull moves. The only problem with that is that we've heard this argument from the bears for years now. I remember doing bull/bear debates back in late 2009 and this was a common argument up the bears' sleeves.

Why is volume so light? My opinion is that we lost a generation of investors over the past 12 years. Two 50% drops will do that. At the same time, the only investors left are more sophisticated. They are investing in options, futures, and ETFs versus individual stocks. When VIX (INDEXCBOE:VIX) options continue to see record call open interest nearly every month, that tells you a more sophisticated investor is out there.

Overall, option and futures volume has actually seen growth since the financial crisis, whereas stock volume hasn't. Lastly, there's been a huge explosion in ETFs during the past several years. Instead of buying individual stocks, you can buy a basket of stocks and hold them. Last week, I was in New York for the annual MTA Symposium. Michael Murphy (a regular on CNBC's Fast Money) said simply that volume isn't what it once was because traders are now using options and ETFs. Fully agree with him.

I mentioned on Twitter recently that low volume is actually bullish and I had some interesting replies. My favorite was @TLMontana, who noted a good deal of the volume anymore is hidden in dark pools. I've read about this before and that's a great point.

Whatever the exact reason volume is low, let's get to some stats that confirms low volume is actually bullish. One way we like to look at volume is something we call total-dollar volume. Of course volume was higher during the financial crisis when bank stocks were all trading under $5. Now the popular names are Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL). You can't quite buy as many shares of those now, can you? Rocky White in our QA department worked with me and we wanted to find what the overall total-dollar volume looked like to get a more apples-to-apples comparison of "now versus then."

We looked at the 500 highest volume stocks and found their daily average dollar volume (stock price times stock volume). Then to smooth things out, we made a 21-day moving average of the results.

Here's a chart of the results. No question, overall total-dollar volume is lower now than it was during the financial crisis. But it is higher than a big chunk of the last bull market from 2003 to 2007! In fact, once volume started to spike higher, that was a big warning sign. The obvious question: During the last bull market, we did see confirming volume though nearly the entire way up -- but during this bull market, we haven't seen that at all. I simply don't know what to say here, other than check out the next study we did.

Just eyeballing the chart above, it looks like moves beneath $100 billion are good times to be long. In other words, low volume is actually bullish. Well, since 2007, we've seen this ratio dip beneath $100 billion 13 times (taking only one signal every 21 trading days to ignore near-term signals). Sure enough, this is extremely bullish. One month later, the SPX is up about 2% on average; three months later, it is up 6.4%; six months later, it is up 8%. All of these trounce the average return over the same timeframe.

Here are all the results since 2007. That late December signal has simply been a huge call. By the way, remember late December when nearly everyone was worried about fiscal cliff? Yeah, maybe we should have been listening to volume instead of the talking heads spewing fear.

In conclusion, stock volume simply doesn't matter like it once did. Or maybe I should clarify -- it doesn't matter on the upside to confirm bullish moves. Low volume isn't bearish no matter how you slice it. In fact, I'd be much more worried if we finally start to see an uptick in overall volume.